Future of Oil Hangs on Iraqi Politics

Fears that events in Iraq will send global oil prices soaring have abated. Yet, the crisis has potentially huge implications for oil. Under any conceivable outcome to the current situation, oil production from Iraq will fail to meet recent expectations. The reason for this dire prognosis is that politics – not security or logistics – will be the biggest determinant of Iraq’s oil trajectory in the years ahead.

In 2012, the International Energy Agency forecast that Iraq would account for 45 percent of the growth in global oil supply from 2012 to 2035. In its projection, the IEA anticipated that Iraq would move to producing more than 6 million barrels a day in the next five and a half years, from 3.3 million barrels a day. Production at such levels would make Iraq the fourth-largest producer, after Russia, Saudi Arabia and the U.S. – assuming all increased their production along projected lines.

In the short term, immediate large-scale Iraqi production disruptions – fears of which briefly drove the price of oil to a record nine-month high in mid-June – are unlikely. Almost 85 percent of Iraq’s production occurs in the deep south of the country, far from the front lines of the confrontation with the Islamic State for Iraq and Syria.

Even if Iraq’s crisis morphs into a sectarian civil war, production in the Shiite-dominated south wouldn't necessarily grind to a halt. Even in the worst years of the 2006-2008 sectarian conflict, production edged upward.

The real cause for concern is a few years ahead, when the world will be expecting to consume Iraqi oil that may still be in the ground. The current conflict, regardless of what turns it takes in the weeks and months ahead, virtually ensures that Iraq will struggle to bring anticipated volumes of oil to market. Consider the oil implications of each of three plausible scenarios:

The worst-case scenario: All of the many variants of this scenario involve some combination of the collapse of Iraqi institutions, the entry of multiple external actors into the fight, and the fragmentation of the country into sections that, at least in the south and west, are ungoverned or without clear authorities.

Sadly, the prospects for this scenario are all too real, and growing more likely as the political stalemate continues and Iraq’s politicians jockey for power. The recent news that Saudi Arabia mobilized 30,000 troops on Iraq’s border, and rumors of Iran using airpower to support the Iraqi government, are worrisome signposts of this sort of future.

Under these circumstances, the Kurds may be able to continue to produce and export their oil, but these volumes will only compensate for a relatively small portion of Iraq’s overall production. Maintaining production in the south, however, will be a challenge if there is no government to perform routine functions such as granting visas and easing equipment imports.

Even before this crisis, such hurdles frustrated international oil companies. Increasing production beyond today’s levels will be even more difficult, due to the reluctance of these companies to spend capital and maintain a presence in an insecure area. Iraq’s own oil companies probably wouldn't be able to carry out the needed work in the absence of the international companies, particularly if the central government ceases to pay salaries, pass budgets, and allocate resources amid the chaos.

The status-quo political scenario: Iraq would limp along – perhaps with a new government, but one that would lack the credibility and capacity to reverse ISIS's gains -- and oil production would continue but increase very little. Iraq’s central government in Baghdad would continue to collect revenue from the sale of the oil, though those resources would be used to build its military forces. The government would be distracted from any effort beyond its political survival and unable to harness the focus and resources needed to execute one of the largest capital projects ever undertaken in the energy industry.

Infrastructure limitations would further restrict export growth. Almost all of Iraq’s southern production is shipped from terminals in the Gulf (a northern pipeline has been incapacitated since March due to insurgent attacks). Plans to increase the outflow are in large part dependent on planned pipeline projects to reach other export destinations.

The recently signed agreement for an $18 billion pipeline to transport more than 1 million barrels a day from Basra to Aqaba in Jordan cannot be realized while the ISIS has control of western Iraq. Renovation of the 1.6 million barrel a day Iraq Strategic Pipeline, which runs the length of the country north to south, will also remain a fantasy if ISIS consolidates power in the territory it holds.

Given these constraints on pipeline exports, in the status-quo scenario, Iraq’s exports would remain capped at 4 million barrels a day -- far less than anticipated by global markets over the next five years.

The silver-lining political scenario: My least-negative political projection for Iraq entails a better future for the country as a whole, but also new political realities that would complicate the expansion of oil production and export. In the long run, Iraq's production could surpass even 2013 projections. The medium-term picture, however, is clouded by uncertainty, with global markets left thirsting for significantly delayed Iraqi production.

In this scenario, the recent unrest galvanizes internal and external forces to collaborate. Iraqi politicians jettison their narrow agendas, discover the art of compromise, and work to build a government that serves Iraqis from all backgrounds. This new inclusive government would provide grounds for Sunnis living in ISIS-controlled areas to support the government's efforts to regain control. The formation of a new Iraqi government would relieve the Barack Obama administration of its legitimate, though paralyzing, concern about intervening in a sectarian conflict and allow more U.S. support for the stabilization of Iraq.

However, even in this optimistic view, which seems increasingly unlikely to be realized, Iraq will struggle to achieve the production increases the world is counting on – because a prerequisite for this outcome is a fundamental renegotiation of the way power is shared and wielded in Iraq.

The Kurds -- who have long been skeptical of the central government’s commitment to a federal, pluralistic and democratic country -- won’t agree to commit to yet another “new” Iraq without consolidating many of their gains of recent weeks, months and years. For instance, any new political understanding will likely need to legitimize the development and sale of oil by regional actors (such as the Kurdistan Regional Government). Until now, the central government has monopolized that power.

Under the silver-lining scenario, the central government could hold the country together, but it would be unable to continue to control all the resources. In addition to the Kurdish region, other provinces of Iraq – both Sunni and Shiite – would demand greater autonomy. The constitution currently allows for a “province” to evolve into a more powerful “region,” but the central government has sought to block or undermine efforts by Basra or other provinces to move in this direction.

The transition from a highly centralized state to a decentralized or even genuinely federal nation would be fraught with setbacks, legal uncertainties, contested developments, and hampered by the lack of capacity in the south. New bid rounds and subsequent investments would be slow to materialize, as multiple layers of the Iraqi government would present themselves as the legitimate interlocutor for international oil companies.

In this “silver lining” scenario, Iraqis will need to develop provincial and regional institutions not only to manage new responsibilities and set regional policy, but also to coordinate between the regions and the central government. International companies operating in Arab Iraq could maintain their positions given the big upside that will eventually present itself, but they could well reduce capital expenditure until the uncertainty dissipates.

In the long run, regional governments in oil-producing Arab Iraq may provide better incentives to international oil companies and prove more responsive as partners. But don’t expect a big dividend in oil production to quickly follow a resolution of the current conflict, even under the best circumstances.

It may be overly optimistic to hold out hope for a silver lining political scenario – but that outcome it isn't impossible. By contrast, there are no reasonable grounds to count on Iraqi oil production to meet the expectations of the global market in the next several years, regardless of the political scenario that unfolds. The U.S., Saudi Arabia, China, and other countries need to accept this reality, and work together to determine the steps needed to address possible future supply imbalances.

To contact the writer of this article: Meghan L. O’Sullivan at Meghan_OSullivan@hks.harvard.edu.

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net.

Meghan O'Sullivan is a professor of international affairs at Harvard's Kennedy School of Government. She served on the National Security Council from 2004 to 2007, and was deputy national security for Iraq and Afghanistan.
Read more.